The outlook for private financing.

Despite a severe hiccup in 1998, commercial mortgage-backed securities look to boom this year for long-term care facilities 

The past year proved to be a roller coaster year for the commercial mortgage-backed securities (CMBS) market. For the first six months of 1998, lenders enjoyed increasing volume as investors readily purchased the CMBS issues. Borrowers enjoyed a gradual compression in coupon as both the Treasury market rallied and CMBS spreads tightened. However, after a confluence of tumultuous economic events around the world this past summer, investor demand briefly evaporated for all fixed-income securities except U.S. Treasury securities. Borrowers quickly felt the impact. The flight to quality by institutional investors was reflected in an upward blip in spreads on commercial mortgages.

Fortunately, rational thinking quickly returned to the markets, with investors realizing that the U.S. economy is fundamentally intact. Capital returned to the municipal and corporate bond markets, as well as to the CMBS markets. Nonetheless, this relatively brief period of volatility in the capital markets left lasting impressions on both commercial mortgage lenders and borrowers, regardless of real estate asset type. Several CMBS lenders closed their doors to new business. Others have waited for improvements in the CMBS market that will allow them to securitize their existing inventory before pursuing new deals. The CMBS industry players who remain in the market will likely maintain underwriting standards and pricing that result in a more uniform product for securitization.

Despite the blip of volatility, this form of mortgage financing is here to stay and offers owners of long-term care properties many advantages. Simply stated, the CMBS industry provides owners with access to the capital markets. By pooling and securitizing these mortgages, Wall Street has provided a bridge to Main Street. The CMBS industry has done this in much the same way that residential mortgages are pooled and securitized, a business that evolved over two decades ago. Lenders fund loans that are then accumulated into large pools. The pools are transferred to a single-purpose entity (a real estate mortgage investment company, or REMIC) that issues bonds, or CMBSs, backed by the pooled mortgages. The cash flow from the mortgages pays the coupons on the bonds. The bonds are rated by agencies such as Standard & Poor's, Moody's, Fitch or Duff & Phelps.

The current environment allows owners to secure a mortgage at a fixed rate of less than 8% for a typical term of 10 years. By historical standards, and compared to some other sources of capital, the rates today are very attractive. Amortization is usually based on a 25-year schedule. Transaction costs are relatively low, the loan documentation is standardized, and deals can be completed in less than 60 days. Once the loans are funded, they are administered by nationally recognized and experienced servicing firms

Financing long-term care properties requires lenders to have additional skills in their underwriting toolboxes. In addition to an analysis of the physical ("the bricks and sticks"), the lender will analyze all aspects of the operating business. The lender must understand the various sources of reimbursement and the regulatory environments affecting each payer class. The lender will also review the operator's experience and historical operations and evaluate the impact on the facility of changes in the local market, as well as state and federal regulations. The real estate is only a small part of the collateral; much of the value is in the business and ability of the operator to maintain and grow that business.

Some of the underwriting information that a lender will require, to ascertain whether a facility qualifies for a CMBS mortgage and to determine its ability to service debt, includes the following:

* Property description: type of facility (SNF, ALF, CC or CCRC) and number of beds or units.

* Facility income and expense history for the trailing 12 months and past two years.

* Payer mix and current reimbursement rates (private, Medicaid, Medicare, other).

* Census report and occupancy history for the trailing 12 months and past two years.

* Copy of the most recent property regulatory survey, if applicable (e.g., HCFA survey).

* Copy of healthcare license (with issue and expiration dates).

* Borrower and Principal financial statements and tax returns.

* Borrower/Principal resumes, including summary of relevant healthcare experience.

* Copy of operating lease and tenant information (if applicable).

* Property management agreement (if applicable).

* Photographs of the facility.

Lenders will be assessing several issues that affect the near-term outlook for senior housing. For example, operators of skilled nursing facilities are now phasing in Medicare's PPS reimbursement procedures. For some facilities, this may mean a substantial reduction in Medicare revenues, while others may see little effect on revenues or even an increase. Lenders will be challenged to underwrite these revenues, particularly since the near-term impact on expenses cannot be easily established. Lenders must also evaluate the impact of trends such as the termination of certificate-of-need requirements or the lifting of moratoriums in some states, and the establishment of Medicaid waivers for assisted living facilities. These challenges will require operators to intensify their marketing efforts and maintain accurate data on all sources of local competition.

From a lender's perspective, the strengths of a successful nursing home can mitigate many of these risks. There are barriers to entry that will preclude exponential growth such as we have seen in certain markets with assisted living facilities. Nursing homes operate with a high degree of government regulation and require top management, administrators and nursing staffs with high levels of expertise and experience to prosper.

The trend toward shifting lower-acuity patients from nursing homes to ALFs is one of the factors driving the explosive growth in ALFs. However, this may be tempered by a near-term correction. Many facilities are being built based on an assumption of a large, affluent and aging population. While we are all aging, not everyone will be able to afford the high rates that many facilities will require to meet pro forma. Further, given the lower levels of acuity, ALF residents will tend to be more transient. A more affluent population will likely be more demanding of quality services and activities. Operators will need to excel in providing services and activities, as well as in marketing, to maintain occupancy. The right combination of location, demographics and operator experience will be necessary to maintain high occupancy rates.

The outlook for financing long-term care facilities is positive. Lenders experienced in financing senior housing understand the challenges facing operators, but they also realize and appreciate that the industry has been around for many years and has survived many regulatory initiatives. The changes to the industry will test operators to more closely monitor costs relative to patient acuity levels. Lenders will look not only to an operator's caregiving expertise, but also at their level of sophistication with respect to cost management and operating efficiency.

CMBSs as a source of financing for long-term facilities are here to stay. The CMBS industry has gone from a total cumulative issuance of approximately $25 billion by 1991 to over $200 billion today. The brief period of volatility last summer has provided the industry with a correction that, in hindsight, is a natural part of any evolving industry. The CMBS industry will stabilize at some level that will result in an acceptable return for both lenders and investors.

At the same time, the CMBS industry will continue to be the primary source for competitive long-term fixed rate mortgages. In and of itself, the CMBS industry has become a major source of capital and has indirectly increased the volume from other sources by stimulating greater competition among all lenders.

Brian Dowd Is a director at Parallel Capital, based in New York City. He has more then 10 years' experience with commercial and multifamily real estate, including commercial loan origination and portfolio management. For further Information, phone [phone]; fax [phone]; or visit the Web site at: www.parallelcapital.com.